Japanese Stocks Lure More Long-Term Investors

Buying by Mutual Funds Suggests Nikkei May Have More Upside

By

Kana Inagaki

Updated Oct. 14, 2013 9:46 p.m. ET

TOKYO—At the start of the year, high-profile hedge funds were piling into Japan's stock market in search of quick, profitable bets. Now, there are growing signs that mutual funds are jumping in for the long haul.

Institutional money managers, which tend to trade less actively than hedge funds, started to ramp up purchases of Japanese stocks in midsummer, after a decisive parliamentary election in July bolstered hopes that Prime Minister Shinzo Abe would be able stay in power long enough to carry out difficult structural changes to the economy, many market experts say.

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Economists say such changes—including tax breaks to encourage investment, more labor-market flexibility and greater participation in free-trade agreements—are key to sustained growth in Japan, which has begun to move past the economic doldrums of the past two decades.

The changing composition of the foreign investor base for Japanese stocks suggests the rally that began at the end of 2012 still has some legs. But it is unlikely the gains will match the breakneck pace from earlier this year. The Nikkei Stock Average soared 80% in six months but then fell 20% in three weeks.

The Nikkei is up 16% from its June low. This month, though, the index has slumped along with other stock markets world-wide amid jitters over the budget impasse in Washington. The Nikkei rose 1.5% on Friday to 14404.74; the market was closed Monday for a holiday.

"We find Japan a very compelling market," says Eric Leve, chief investment officer of Bailard Inc., a San Francisco firm with $1.3 billion of stocks under management. Mr. Leve cited positive economic indicators, such as annualized growth of 3.8% reported in the April-June period. He said he expects the recent weakness in Japanese stocks to dissipate once the standoff over the U.S. debt ceiling is resolved.

Bailard lifted the amount of Japan exposure in its international equities fund to 21.7% in September compared with 17% at the end of June, according to Morningstar.

Mutual funds and other funds that mostly buy stocks to profit from rising share prices have, as a group, been buyers of Japanese stocks since June, said Patrick Hogan, co-head of Japan equities at Bank of America Merrill Lynch. An investor conference in Japan held by Merrill Lynch in September drew nearly 500 foreign investors, the highest number since the event started a decade ago.

After selling in August, foreign investors returned as net buyers of ¥806.43 billion ($8.18 billion) of Japanese stocks in September, according to data from the Tokyo Stock Exchange. While that is off the peaks hit in April, when the Bank of Japan83010.74% launched a massive easing program, the renewed buying ran counter to some expectations that foreign-investor interest in Japan had faded. The data don't show breakdowns between hedge funds and mutual funds.

The lure of Japanese stocks comes with potential pitfalls. A major driver of the stock market has been an improvement in corporate profits in Japan. This is due largely to a weaker yen. However, a weak yen erodes the returns of foreign investors, who count their gains in dollars.

So far this year, though, any losses in the yen have been more than offset by the stock market's nominal gains. With the yen down 12% against the dollar, the Nikkei is up 20% in dollar terms, compared with an increase of 39% in yen terms.

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Mr. Abe deserves credit for sending investors clear signals about his economic agenda, helping convince some to take a chance on Japan, said Daisuke Nomoto, a senior portfolio manager at Columbia Management Investment Advisers LLC, which oversees $4.5 billion in international stocks.

During a speech at the New York Stock Exchange in September, Mr. Abe shouted, "Buy my Abenomics!"

"A government official I spoke to recently said there's no concept of failure in Abenomics," Mr. Nomoto said. "They'll continue at it until they succeed."

Mr. Nomoto, who oversees a $300 million Pacific Asia fund, increased the fund's Japan exposure from 32% at the start of the year to about 40% by the end of August. That is the highest level in the past three years.

Mutual-fund managers are taking up some slack from hedge funds. Hedge funds Third Point LLC, Greenlight Capital Inc., Hayman Capital Management LP and Soros Fund Management LLC were making big wagers on a lower yen earlier in the year. Some funds were also betting that Japan's stock market would rise as a result.

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The Nikkei is up 16% from a June low. Above, the Tokyo Stock Exchange floor.
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At Tora Trading Services Ltd., a trading technology firm backed by Goldman Sachs Group Inc.,GS-1.03% volumes of orders from hedge funds were down 25%-30% in July and August compared with the average of the prior quarter, according to chief investment officer Keith Ducker.

Still, even investors who are positive about the Japanese market outlook for the next year or two say they are less certain about the longer-term future, absent bigger structural changes. In the January-March quarter, the Fourth Swedish National Pension Fund, which has around $38 billion in total assets, increased its investment in Japanese equities to $1.5 billion, up around $400 million from last year, according to its chief executive, Mats Andersson.

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